Sudden stops in international finance

The term 'sudden stop' refers to a sudden reversal of capital flows into a country. A country may be attracting large volumes of international capital for many years. Then, at some point, the inflow of international investment goes in reverse. An example is the portfolio equity investment to Indonesia displayed on the chart.

Causes. A number of factors could precipitate such a sudden stop but the most important one is usually an increase in U.S. interest rates. When the U.S. Federal Reserve increases interest rates (to cool down the U.S. economy), then international capital starts to leave emerging markets and heads to the U.S. where it can enjoy higher returns and significantly less risk.

The reason for the sudden stop could also be related to domestic conditions. There could be news of political instability or an economic slowdown that discourages foreigners from investing. Or, the reason could be panic related to investments in emerging markets as a whole. Then foreign investment stops everywhere regardless of whether or not the country has any specific problems. The case of Indonesia and other South East Asian countries that experienced a sudden stop in the mid-1990’s was to a large extend prompted by widespread investment panic and contagion.

Effects. When foreign investment stops so suddenly, the country usually suffers from a liquidity crisis. In normal times, new international investment is used to pay the interest on existing international debts. Now, all of a sudden there is no new international investment. The country has to use its foreign exchange reserves to service its debts. However, the reserves are limited and as they decline, the investor panic intensifies and, usually, the currency depreciates sharply. This creates inflation and a steep recession.

Prevention. To avoid such a scenario countries try to do several things. First, they try to not depend too much on foreign capital and try to not accumulate too much foreign debt. Second, they try to attract more foreign direct investment (i.e. production facilities owned by foreign firms) instead of portfolio investment (debt and equities) because FDI is more stable and less susceptible to sudden stops and reversals. Third, they try to keep large foreign exchange reserves that are used as a buffer if a sudden stop occurs.

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